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Essential Economics from ASPL - Part Two

18.06.2013

Most of our clients have a reasonable grasp of basic economics through their businesses or the media, and we thought it may be useful to provide a little more background for those who are interested.  This is the second in a small series of articles produced with this in mind.

In part one of our Essential Economics series, I wrote that economics is all about how people deal with scarcity and it wasn’t until the late 18th Century, in England, that the Industrial Revolution got started and living standards in many countries rose significantly and continued to rise.

The world faces many challenges going forward, some of which are the consequences of our early successes. Knowing what we know in the West about pollution and resource depletion, it’s hard to watch the Indias and Chinas of this world making similar mistakes as the nations develop.

Macro Economics and Micro Economics

Macro Economics looks at economy wide factors such as interest rates, inflation and unemployment.  How Governments use monetary and fiscal policy to try to moderate the harm caused by recessions.  The economy as a whole.  Macro economics is the stuff of the big picture that gets reported on in the news.

Micro Economics focuses on individuals and individual businesses.  How we behave when allocated resources when competing within markets.

Underlying both Macro Economics and Micro Economics are some basic principles, such as scarcity and diminishing returns.

Scarcity is the fundamental and unavoidable phenomenon that creates a need for the science of economics.  Scarcity is where you can’t have everything, even if you are the richest person in the word.  Sadly, scarcity is a fact.  Too little time and stuff exists to satisfy all our desires, so people have to make hard choices about what to produce and consume.  The phenomenon known as “diminishing returns” describes the sad fact that each additional amount of a resource that is thrown at a production process brings forth successively smaller amounts of output.

Like scarcity, diminishing returns is unavoidable.

Macro Economics

Gross Domestic Product (GDP) is the value of all goods and services produced in the economy in a given period of time.

Inflation measures how prices in the economy change over time.  This topic remains crucial, because high rates of inflation usually accompany huge economic problems (deep recessions, countries’ defaulting on their debts and so on).

Studying inflation is also important because poor Government policy is the sole culprit behind high rates of inflation.

Recessions – two consecutive quarters of negative economic growth only linger because institutional factors in the economy make it very hard for prices in the economy to fall.  If prices could fall quickly and easily, recessions would quickly resolve themselves, but because prices can’t quickly and easily fall, economists have had to develop anti-recessionary policies to help get economies out of recessions as quickly as possible.  John Maynard-Keynes is the man most responsible for developing anti-recessionary policies.

Two things that can help an economy get out of recession are so-called “monetary” and “fiscal” policy:

Monetary Policy uses changes in the money supply to change interest rates in order to stimulate economic activity (e.g. if the Government can make interest rates fall, the public borrow more money to buy things, thereby stimulating economic activity and helping the economy to get going).

Fiscal Policy refers to using increased Government spending or lower taxes to help fight recessions (e.g. if the Government spends money on goods and services, economic activity increases.  Similarly, if the Government cuts taxes, we end up with higher after-tax incomes which increase economic activity as we spend it).

In the first decades after Keynes’ anti-recessionary ideas were put into practice, they seemed to work really well.  However they didn’t fare so well during the 1970s and it became apparent that although monetary and fiscal policies were powerful anti-recessionary tools, they had their limitations.

Part of the reason as to how and why monetary and fiscal policies have limitations is because of the key concept called “Rational Expectations”.

Rational Expectations explains how rational people very often change their behaviour in response to policy changes, in ways that limit the effectiveness of these changes.

By Adrian Smith

Other articles in this series:

Essential Economics from ASPL - Part One

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